The Housing Crisis: Caused by the Bush Tax Cuts

by James Livingston

Mr. Livingston teaches history at Rutgers. He's finishing a book called The World Turned Inside Out: American Thought and Culture at the End of the 20th Century.

I don’t know about you, but watching the markets get crazy has been great fun for me. Once upon a time I wrote a book on the origins of the Fed, so every time I read about the “moral hazard” involved in bailing out insolvent lenders—or borrowers—I have to laugh. This hazard lies in thwarting the logic of the market, according to the old-school economists and journalists who preach it.

If you violate this logic—if you don’t let the market cleanse itself of imprudent investors, mere speculators, and the like—you have validated precisely what the market should be punishing. You have not let the market do its anonymously moral work of enforcing a transparent relation between honest effort and legitimate reward.

In a corporate age of globally administered markets and prices, this is a pretty flimsy argument, of course, but it keeps surfacing in the Financial Times, and even in Paul Krugman’s op-ed of August 17 in the New York Times, where the distinction between speculative lenders and hard-working borrowers is pushed to its logical conclusion. I still like the piece because he introduces a comparison between third-world debtors and strapped mortgage holders here in the good old USA; but the market is not a moral calendar, no matter how well-regulated.

The origins of this credit crunch—maybe even a crisis—reside, by all accounts, in the housing market. Big banks bought up a lot of sub-prime mortgages, then bundled them into portfolios that could be sold downstream as reliably income-producing assets. Thus mortgage debt was “securitized,” made into something hedge funds and private equity firms, and even stodgy mutual funds, could buy into as an investment, not as a side bet. When the housing market flattened out, that is, when prices and construction began to fall and when foreclosure rates began to rise over the last two years—even with interest rates relatively steady—this mortgage debt suddenly looked dubious.

The bubble burst, in short, when everybody realized that the long-term inflation of residential real estate prices, which started about a decade ago, was over, maybe even in Manhattan.

Our questions should then be, why did this huge investment in subprime mortgages take place, and why should dismal forecasts on the housing/mortgage market affect all others? The short answer to the first question is George W. Bush’s tax cuts—and this answer should give the Democratic candidates another reason to repeal them.

The rationale for these cuts came from the supply-side arguments of the 1980s (personified by Dick Cheney). It goes like this. Investment, productivity, and employment will increase if you augment the incomes of those who do the saving and investing. These already wealthy folks will acquire a new monetary incentive to invest in goods production if you raise their disposable incomes by cutting their taxes. That investment will in turn produce larger payrolls and more taxable incomes, thus canceling the revenue-reducing effect of the original tax cuts.

Then as now, these supply-side arguments have two defects. First, the history of the 20th century is the record of increasing productivity and output as functions of declining net investment. Economic growth doesn’t require greater investment after 1919, in other words, so it certainly doesn’t need higher profits or executive incomes. In fact, any shift of income shares away from labor and toward capital—any shift away from consumption and toward saving or investment—will be a cause of crisis, not of growth.

For if higher profits aren’t needed for investment in goods production (the “real economy”), they will force their way, as unruly surpluses, into the available speculative sites, for example into the stock market of 1926-29. Or into “high-end consumption.” Or into subprime mortgage lending. Whatever.

The recent private equity mania (“leveraged buy-outs” of publicly traded companies) exemplifies these three tendencies of overwhelming capital surplus, as Ben Bernanke often said before he took up his more taciturn duties at the Fed.

But the stock market has not been as reliable as long-term investors and short-term scalawags alike would want. The dot.com bust still spooks everybody except me, but I’m the historian who compares it to the crash of 1901-02. And how many yachts can a rich man steer toward his own private coast of utopia? Where else to turn? To the housing/mortgage market, of course, the available speculative site where prices were surging after 1995, even after the stock market tumble of the turn of the century.

Second, tax cuts have never, I repeat, have never caused increased investment—not in the 1920s, not in the 1960s, not in the 1980s, and not in our own time. The empirical record is uniform: net investment keeps falling no matter what. Don’t take my word for it. Consult Peter G. Peterson, a co-founder of Blackstone (a private equity group just gone public), and a former cabinet member under Nixon and Ford.

There is no cause-effect correlation between lower taxes and greater investment because, again, economic growth no longer requires, or even allows, increasing net investment. At the macro level, we can improve productivity and output just by replacing and maintaining our existing capital stock—we certainly don’t have to make any additions to it.

So to cut taxes for the wealthiest individuals is to invite them to place their augmented incomes in the hands of people who have no choice except to bet this new money on the available speculative site, in this instance on the housing/mortgage market. There’s no place else to put it if they want to get a return better than a savings account or a stodgy mutual fund. It was a “liquidity driven bull market,” as David Rosenberg, the chief economist at Merrill Lynch, puts it (FT 8/16/07). And it has regulated all others because the bulk of the surpluses generated by tax policy went there. When it turned, everything else did.

The housing bubble was part of economic growth in the last six years, don’t get me wrong. But notice that it was first driven by “high-end consumption,” then by subprime consumption of housing, not by an original investment in goods production. It created employment in the building trades and put demand on industries that fabricate construction materials because consumption as such had long since become the leading edge of economic growth.

But what is to be done? Yes, let’s repeal the Bush tax cuts and shut off the “high-end” source of the speculative boom in housing/mortgages—also the source of the boom in mergers and acquisitions, the bread and butter of private equity. And yes, let’s subsidize “low-end” consumption of housing (among other things), to begin with by mobilizing Fannie Mae and Freddie Mac on the Gulf Coast. In view of its pathetic performance in the real world, why not reverse the vector of the supply-side argument and start writing loans the way we write history, “from the bottom up”?

Meanwhile, however, can we leave this crisis in the hands of the bankers? It all depends on which bankers we’re talking about. Also when. One of the architects of the Federal Reserve System, Paul Warburg of Kuhn-Loeb & Co., declared—this is in 1910—that “money making and the maintenance of a safe proportion between cash and cash obligations are at times distinctly opposed functions.” Translation: if you let the banks scramble individually and competitively for liquidity in times of financial crisis, in the name of the profit motive at the micro/firm level, you destroy the system; at that point nobody gets to be motivated by the possibility of profit.

People like Warburg still populate the global financial system—think of Joseph Stiglitz, who fought the good fight at the World Bank, and who now writes bracing books about globalization and its discontents. Better yet, think of William Poole, the president of the St. Louis Fed, who has been quoted repeatedly in the last few days as an old-school, “moral hazard” kind of guy. In the front page, lead story in the Financial Times last week, for example, Poole is quoted as saying that only a “calamity” would justify an interest rate cut before October, when the official subcommittee of the Fed is to meet (his remarks were later disavowed by a Fed spokesperson, which means rates fall in September).

Poole is clearly the go-to guy when you want to talk about the “moral hazard” central banking entails. Let the market do its cleansing work, he seems to be saying, let the losers take their losses. But then you re-read Martin Wolf’s curmudgeonly column in the FT of August 16, and you wonder what planet St. Louis is on—it can’t be capitalist America. Wolf, an erudite economist with a great sense of humor, says he loves the business cycle because it purges the system of the imprudent and the speculative investors; the market, he insists, needs fear of falling to keep it honest. Then he quotes Poole approvingly as follows.

“When William Poole, chairman of the St. Louis Federal Reserve, said that ‘the Fed should respond to market upsets only when it has become clear that they threaten to undermine achievement of fundamental objectives of price stability and high employment or when financial market developments threaten market processes themselves,’ I give a cheer.”

Me, too. Three cheers from me. This is Warburgian rhetoric on the melodramatic level of opera written by Brecht. Poole is saying that we need to use the central bank’s full powers when financial crisis threatens market forces as such—forces he knows are already administered. And notice the two “fundamental objectives,” normally construed as antithetical goals on the supply-side of town. In this conspectus, the market is far from an anonymous set of forces to which we must submit for our own good. Instead it’s something we manipulate in the name of social goals such as “high employment.”

Like the Dude, who unwittingly foiled the venal plans of the Big Lebowski, a loud-mouthed neo-conservative, socialism somehow abides in our America, even where finance capital has taken up residence.

So if my retirement account is at risk just now, I’m not that worried. Markets have been socialized to the point of—oops—no return, by the very people who still believe in their moral contents and imperatives.

Derrick Simpson -
11/2/2010

Erik Rose -
9/30/2008

Wow. I like how you totally avoided the root of the whole problem. This all comes down to sub-prime loans. What caused these sub-prime loans to become so prevalent in the first place? Could it be the Democrats push to get more and more minorities and low-income folk into homes that they could not afford? Could it be the pressure they placed on Fannie/Freddie to lower their standards and accept these risky loans? You are conveniently ignoring a huge part of this debacle because it doesn't further your own agenda. Market tinkering by Democrats was a HUGE factor in this mess and we'll never solve the problem as long as people like you keep trying to point the finger at someone else. There's enough blame to go around for everyone, how about your Party accepting their share?

James Livingston -
10/6/2007

Yeah, really.

This reply is probably too late, but it's not a matter of what you believe--we are not engaged in a faith-based initiative. It's a matter of what I can prove. Your faith is derived from conventional economic theory, my argument is derived from another set of sources, which has more explanatory adequacy in the age of disaccumulation.

See my subsequent posts here at HNN, or read Part I of my 1994 book, Pragmatism and the Political Economy of Cultural Revolution (UNC Press), for that other set of sources.

Paradigm shifts always involve disbelief--and its suspension in the name of intellectual (also political) progress.

Lawrence Brooks Hughes -
8/30/2007

I've been playing the market for 10 days and listening to a torrent of commentators' views on the mortgage situation. I have come to the conclusion we are NOT going to have a national or international panic--the only real risk there was, since business is brisk, employment is high, and all big banks are very sound. (Yes, all). Besides, we have federal firemen at the ready with their hoses broken out. Those 500 and 1,000-point drops in the Dow never showed up. If you watch the CNBC talking heads all day you notice the liberal gurus have been muttering about recession, depression and use the phrase "millions of foreclosures," while the more intelligent (and haughty) conservatives rebut them with facts and no little derision. It strikes me the Democrats are rooting for a Bush depression to go with what they think is a lost Iraq war, but every day they come closer to the realization they will be wrong on both counts. We have already created a friendly and quasi-democratic new state in the heart of of the Middle East, and the Lord must have loved those who will NOT get thrown out of their homes, because He made so many of them!

rob dorst -
8/27/2007

I don't believe it.
If the tax-cuts were invested in housing, savings would have gone up.
This didn't happen.
Simply put:
Taxes were cut; the extra money was used for consumption, so savings stayed low; but investment was higher than savings, so money came in from Japan, China, OPEC etc. (look at the trade and current account deficits)

Nonpartisan -
8/26/2007

as always.

James Livingston -
8/23/2007

I appreciate these comments, esp. the reference to the S & L debacle. But you remind me of what I'm trying to follow up on now--how the Fed functions as a lender of last resort to consumers, how it has taken a "retail" role in this latest credit crunch. A very different role than originally envisioned. And again, a species of socialization, through which market forces are modulated, even neutralized.

Lawrence Brooks Hughes -
8/21/2007

This morning the Secretary of the Treasury remarked that the present market malaise was caused by "bad lending practices." I think he probably knows what he is talking about. It was not the bundling of bad loans which did the trick, but rather the poor quality of the underlying paper... There can be "moral hazard" only when governments decide on regular bail outs, such as they have done so often with international loans to "developing" countries... You are entitled to your opinions, and I am entitled to mine. Personally, I'll support the historic tax-cutting experiences of Andrew Mellon, John F. Kennedy, Ronald Reagan, and George W. Bush--which now have been copied with like success all over the rest of the world... I rank Pete Peterson, the ersatz Republican, ahead of Paul Krugman, the crazy liberal, since Peterson had the smarts to make himself a large fortune. But neither of those two gentlemen ever seems to be playing with a full deck.

James Livingston -
8/21/2007

In theory, greater investment is necessary. In practice, that is, in history, it is not. Your charge of absurdity derives from economic theory that excludes empirical data on the sources of growth in the 20th century--it has nothing to do with the history at issue. Since this is a site devoted to historical questions, I have to wonder why you want to want to make these faith-based pronouncements. Oh, and I don't hate America. It's my country: I love it. This affection has no bearing on my analysis of the financial markets. Your "America first, last and always" attitude is the ultimate absurdity because it disallows a rational approach to the problem of "moral hazard." But go ahead, you keep the faith.

Barbara Timmer -
8/20/2007

Excellent article and analysis, so reminiscent of some of the fine writing during/after the S&L crisis . . . and once again the real "trickle down" effects, in everyday dollars, will be the costs to middle class borrowers, and mid-level companies. Passed on/down, which is what unregulated markets not only allow, but encourage. When the Fed "protects" depositors with accounts of $100,000, it is buying such good, cheap PR . . . meanwhile it saves the banks and largest of corporate buyers billions by changing the interest rate spreads . . . I get older, I get cynical . . .

Lawrence Brooks Hughes -
8/20/2007

Don't forget all those proud claims from the White House in recent years about the unprecedented rise in non-white home ownership. Faith can move mountains, but so can elimination of down payments and delay of interest deadlines. Nevertheless, the stock market today is still 10-12% higher than it was a year ago, prosperity has soared all over the world, and we are doing many things right--not the least of which is maintaining the Bush tax cuts. A few foolish experiments in some very small corners of the vast mortgage emporium could go completely awry without any meldtown. We have so much money invested behind every job in America, it is absurd to contend we do not need ever more investment, ever more profit, and ever more reward for investors. It is equally absurd to suggest we will not get them, given our system of guaranteed property rights, enforcement of contracts, government stability. People do not march in the streets and set off bombs here. I have all my money invested in the U.S.A., and a great many foreigners do, too, because it is quite simply the safest and best place on earth to invest it. Those who have bet otherwise can never win but temporarily. It would be crazy not to stick with the champion. Whenever the U.S. markets go down, it is time to buy, not sell. We can even survive a Democratic Congress and president, if necessary. (Provided they don't appoint too many rabid judges). I believe the 21st century will be more of a cornucopia than the 19th and 20th combined. We are now on the cusp of another blast off into more fantastic progress and material prosperity for humankind. Hunker down with the chronic Cassandras or hate-America types, and you will be standing in the station after the train pulls out--again!

Jason Blake Keuter -
8/20/2007

The author is also wrong, if you look at the sale of government securities - which is an investment. Huge tax cuts tackled with a lack of spending cuts equals a massive transfer of funds into government bonds.

Jason Blake Keuter -
8/20/2007

People who bought expensive houses with expensive variable rate loans are unable to sue for breach of contract because what is happening to them right now was explicitly stated in the terms of their loan. How is that a crisis and why does it argue for more regulation? True, if the strangulators...I mean regulators had been there to draft laws prohibiting these kinds of transactions, then this problem wouldn't exist; but on the other hand, all those people not losing their homes wouldn't have any homes in the first place. IN other words, what the strangulators propose to avoid this kind of "crisis" is to simply thwart the irrational economic activity that provides great opportunities to the rational. There are more people keeping homes because they can afford their mortgages than not. Throw in a regulator arbitrarily adjucating other people's lives, and many of those people wouldn't have homes....unless they managed to bribe the regulator.

And now on to the actual costs of regulation (dismissed by strangulators as "free-market" purism and pie in the sky theory that exists to provide cover for the enrichment of specualtors - a Marxist and ugly populist line ith a long anti-semetic lineage) :

it requires spending money on bureaucrats who have a vested interest in denying people the right to engage in an economic transaction in order to demonstrate their own necessity. This replaces market forces with the arbitrary whim of the faceless bureaucrat.

the process of getting approval for the economic transaction is cumbersome and time consuming and thus prohibits other transactions that could take place, thereby stunting growth. further, the regulations simply inhibit buying whatever is regulated in the first place.

money that could be used meeting people's needs (not the ones you think people should meet - the ones free people choose to prioritize and attempt to meet on their own) is used instead paying for regulations.

Justifiably, the regulations are seen as arbitary and, in a democratic system, people will complain. the regulators will not close shop, instead, there will be calls for oversight, which means regulators to regulate the regulators.

of course, all of this is a big boon for those tax-consuming "professors' fantasizing about a return of the brain-trust - unfortunately, it's also a good way to take temporary crisis justly suffered by poor decision makers and make them permanent. In other words, this piece and the other argue for more government so that bureaucrats can make decisions that cause other people to suffer and then reap the reward of more bureaucracy in face of "crisis". In a real democracy, when the government makes mistakes, the government suffers. In the regulators world, the regulators make all sorts of mistakes and other people suffer.

Of course, you can then go out an galvanize masses of voters that won't bother to read their mortgage agreements to take on the bureaucracy and you'll be sure to achieve results immediately.